John Pearce, chief investment officer at Unisuper, is one of Commonwealth Bank’s (ASX: CBA) biggest fans. In contrast to Perpetual’s (ASX: PPT) ex-investment chief Matt Williams – who recently said going underweight CBA in 2014 was his biggest mistake in an otherwise stellar career – Pearce is overweight the world’s most expensive bank.
Pearce believes financial ratios such as price to tangible book value have no relevance to his fund’s members, who are more concerned with yield. That’s because book value is an inherently uncertain concept, with true value never being known except in a liquidation.
No qualms there. But comparing the price-to-tangible-book ratio over long periods can illuminate how richly valued a business is. If you believe in reversion to the mean, then you’ll think twice before buying CBA shares at a current multiple of 3.8, compared to its long term average of around 3. Keep in mind it fell to 1.8 during the GFC and Australia never even experienced a recession.
Over time a business may become more or less valuable, so the multiple of book value that you’re prepared to pay may change accordingly. But banking is an industry as old as the hills, and not much has changed over the decades. People borrow money, asset prices increase, speculation increases, more money is lent, and eventually a recession purges the bad investments and the process starts again.
‘This time is different’ are some of the most dangerous words in the investing lexicon, so consider this. CBA has $16 of assets for every $1 of equity capital, mostly in the form of mortgages, riskier personal and business loans and other forms of credit, such as credit cards. That means a 6% fall in the value of these assets would wipe out CBA’s equity, rendering it bankrupt.
By way of comparison, Westpac (ASX: WBC) and ANZ (ASX: ANZ) are similarly leveraged at around 16x, while NAB (ASX: NAB) is even more leveraged at over 18x.
I’ve no doubt that the government and RBA would use the same playbook as the Americans to rescue the big four banks in a crisis. But that doesn’t mean your investment would be safe. The banks would likely raise billions of capital through dilutive capital raisings, leading to lower earnings per share and much lower dividends.
Keep in mind provisions for doubtful loans are currently at historical lows, while housing prices in major areas are reaching all time highs. The cushion designed to protect against bad debts has little stuffing.
As the recent collapse in the oil price showed, macro-economic changes can be rapid and severe. The best protection against these threats is owning stocks offering a margin of safety, and CBA surely lacks one at current prices despite its high quality.
If you’re one of Unisuper’s 400,000 members, or an investor in any typical Australian fund that’s neck deep in the big four banks, make sure the rest of your portfolio is adequately diversified. The future is uncertain, and eventually there will be safer and more prospective times to buy the big banks.